Stablecoins under fire

News / Rik Wienke
Last week, stablecoin TerraUST went down together with Terra Luna.

We look back at a rough week in the crypto markets. Cryptocurrency Terra (LUNA) lost 99% of its value after corresponding stablecoin TerraUSD (UST) was unable to keep its 1-dollar peg. Stablecoin UST stole the spotlight, but other stablecoins also found themselves in dire straits; USDT temporarily lost its peg to the dollar as well, dropping to a price of below $0.95.

The collapse of Terra

Terra’s troubles started when large sums of UST were being sold, and the stablecoin couldn’t keep its peg of one dollar. This created unrest in the markets, resulting in large drops for the prices of both UST and LUNA. In one week’s time, LUNA’s price declined from 80 dollars to less than one cent, while the value of UST fluctuated between $0.05 and $0.90 in the same timeframe. Where the Terra ecosystem was worth more than 40 billion dollars last week, it’s currently worth just a fraction of that.

The cause of all this can be traced back to the way these two tokens are intertwined. LUNA and UST are coupled together by a complex algorithm that uses supply and demand to influence the price. In the original design of the project, LUNA helps UST to keep its 1-dollar value, but due to the large sales of UST, the algorithm was unable to keep up and the coin lost its peg. The value decline caused more people to want to exit the project, which in turn caused a large amount of selling pressure on LUNA. Next to that, the algorithm causes the amount of LUNA in existence to increase when the value of UST is below one dollar, which contributed to the exponentially increasing vicious spiral downwards.

Do Kwon, the CEO of Terraform Labs, announced this May that the LUNA Foundation Guard (LFG) had $3.5 billion of reserves at its disposal, of which $1.5 billion were in bitcoin. The expectation was that this would be enough to compensate for any price instability in UST, which in the end did not seem to be the case.

The reliability of stablecoins

Whether or not the situation around Terra means that we need to be more careful with stablecoins in general going forward is hard to predict. The reliabilty of any stablecoin depends on its stabilisation mechanisms and the collateral it has.

First of all, the way these stablecoins retain a stable value is an important factor to look at. For stablecoins like USDT and USDC this is a pretty simple affair: if the demand rises, the supply needs to rise accordingly and more collateral needs to be held by the organisations behind these stablecoins. Those organisations are Tether for USDT and Circle for USDC. This collateral consists of a relatively safe and liquid combination of cash, securities and bonds. This is different for TerraUSD; UST is an algorithmic stablecoin which uses complex processes to keep the dollar peg. Collateral only plays a minor role in such systems.

Next to the role that the collateral plays in the stabilisation mechanism, we also need to keep the contents of this collateral in mind. USDC goes through monthly audits by independent accountants and is accordingly viewed as very safe. USDT, however, has been criticised for many years because there are doubts about the risks the Tether foundation takes with its collateral. The lack of transparency is one of the largest points of criticism in this debate.

Despite the volatility and unrest in the markets over the last week, both USDC and USDT managed to keep their peg. This is a market signal of trust in these stablecoins, pointing out a clear difference between TerraUSD and stablecoins like USDT and USDC.

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